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Offshore Income Tax Exemption

Basis of Taxation in Hong Kong

According to the Inland Revenue Ordinance (IRO) of Hong Kong, a company is subject to profits tax if,

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the company carries on a trade, profession or business in Hong Kong;

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the trade, profession or business derives profits; and

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the profits are derived from Hong Kong (i.e. the profits are sourced in Hong Kong).

Hong Kong adopts a territorial basis for taxing profits derived from a trade, profession, or business carried on in Hong Kong. In other word, a company who carries on a business in Hong Kong but derives profits from another place is not required to pay tax in Hong Kong on those profits. Profits tax is not applicable to profits whose source is outside Hong Kong.

Hence, the location of where a company’s activities take place is the key to whether a company’s profits are taxable in Hong Kong. If profits are earned from activities that take place entirely outside of Hong Kong, then these profits would not be taxable in Hong Kong even if the company’s transactions are carried out through the company’s Hong Kong bank account.

What Constitutes "Hong Kong Sourced Profits”?

The Courts have over the years considered the subject of the source of profits. The Inland Revenue Department (IRD) in its web site has provided certain board principles based on various court decisions:

Matter of fact

The question of locality of profits is a hard, practical matter of fact. Whether profits are derived from Hong Kong depends on the nature of the profits and of the transactions which give rise to such profits.

The operations test

One broad principle in determining the source of profits is to see what the company has done to earn the profits in question and where the company has done it. In other words, the proper approach is to identify the operations which produced the relevant profits and ascertain where those operations took place.

Principal place of business

A company may maintain a business presence overseas which earns profits outside Hong Kong but the absence of a business presence overseas does not, of itself, mean that all the profits of a Hong Kong business are derived from Hong Kong.

However, if a company’s principal place of business is located in Hong Kong and there is no business presence overseas, profits earned by that company is likely to be considered as Hong Kong sourced.

Place where decision is made

The place where the day-to-day investment / business decisions take place is only one of the factors to consider in determining the source of profits. However, it is not generally the deciding factor.

Non-profit generating activities

In determining the nature of business activities that give rise to the profit, only profit-generating activities of the company are taken into consideration. As such, general administration activities do not qualify as profit generating activities.

Guiding Principles on Profits of Trading Firms

Contracts for purchase and sale of goods

An important factor that determines the source of profits from trading in goods and commodities is the place where the contracts for purchase and sale are effected.

"Effected" does not only mean that the contracts are legally executed. It also covers the negotiation, conclusion and execution of the contract terms.

Factors to consider include: How were the goods procured and stored? How were the sales conducted? How were the orders processed? How were the goods shipped? How was the financing arranged? How was payment effected?...etc.

Circumstances to consider

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If the contracts of purchase and sale are effected in Hong Kong, the profits are subject to tax in Hong Kong.

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If the contracts of purchase and sale are effected outside Hong Kong, the profits are not taxable in Hong Kong.

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If either the contract of purchase or the contract of sale is effected in Hong Kong, the initial presumption is that the profits are taxable in Hong Kong. However, other relevant facts will have to be examined to determine the source of profits.

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If the sale is made to a Hong Kong customer (including the Hong Kong buying office of an overseas customer), the sale contract will usually be taken as having been effected in Hong Kong.

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If the effecting of the purchase and sale contracts does not require travelling outside Hong Kong but is carried out in Hong Kong by use of telephone, or other electronic means including the Internet, the contracts will be considered as having been effected in Hong Kong.

Guiding Principles on Profits of Servicing Business

The place where service is performed

For servicing business, the source of the income is the place where the services are performed. If services are performed in Hong Kong, the income has a source in Hong Kong.

In the event that the service income is earned by a company carrying on a business in Hong Kong but the services are performed entirely outside Hong Kong, the service fee is not taxable in Hong Kong.

Offshore Tax Exemption Claim

In general case, the claim for offshore tax exemption is lodged together with the submission of the first profit tax return.

For newly incorporated company, the first profits tax return notice will be issued by IRD in 18 months after the date of incorporation.

The profits tax return has to be filed together with the following documents:

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A certified copy of the Financial Statement and Profit and Loss Account/ Income Statement;

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Auditor's Report;

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A tax computation with supporting schedules showing how the Assessable Profits is arrived at;

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Offshore tax exemption application if applicable.

IRD will normally request the company to provide additional information and documents to support the claim. IRD may review randomly selected transactions and check whether the various activities involved in these transactions were taken place offshore.

It is therefore advisable to keep complete transaction records to illustrate the fact that all activities were taken place outside Hong Kong such as: